As Congress gave its final seal of approval to the tax bill, wealth managers continue to work out where it leaves high net worth clients and even their own businesses.

After the House of Representatives this week approved the most sweeping US tax changes in three decades, reducing overall tax by $1.5 trillion, the wealth management industry is digesting measures that, as previously reported here, could affect not just clients but firms themselves.

Feedback from firms to Family Wealth Report clearly indicates that the effect on individuals’ tax positions, particularly in the case of estate tax and income tax changes, will drive advisors’ heaviest workload as 2018 gets under way. (For a report on the main proposals and likely effects, see here.)

As previously stated, a doubling of estate tax exemptions is arguably the most important impact on high net worth client in the US.  

Several commentators were keen to stress that many of the changes don’t run beyond 2025.

“The doubling of the federal gift, estate, and GST tax exemptions until 2026 will provide significant wealth transfer opportunities for high net worth families,” Jonathan M Forster, a shareholder and chair of the tax and business group at Greenberg Traurig, the law firm, told this publication. 

What advice would he give to people figuring out the impact on their lives?

“Make gifts, particularly to irrevocable trusts so assets remain out of the taxable estate even after the sunset in 2026. Families are not constrained here as under the 2001 tax cuts, which capped the gift tax exemption to $1 million,” Forster said.

“Further leverage gifts by combining them with freezes, like GRATs or instalments sales to grantor trusts that transfer additional value without requiring the use of exemptions. These techniques generate almost no taxable gifts and only transfer asset appreciation above set hurdle rates, which benefit from the current low (but rising) rate environment,” he continued. “Provide an additional wealth transfer without added gift tax by creating grantor trusts and paying the trust’s tax liability. The trust assets effectively grow income tax-free. The greater the income tax liability (for example, in higher income tax states), the greater the wealth shift,” he said. 

“Most trust assets won’t receive a basis step-up at the donor’s passing.  Trusts should incorporate options like powers of substitution or appointment to ensure low basis assets can be brought back into the estate for the step-up. 

Forster also suggested individuals should consider cash value life insurance, which he said offers investment into an uncorrelated asset class, offer a mortality hedge, can serve as a lifetime retirement savings vehicle, and provide immediate liquidity to the family, protecting against market volatility. 

As already noted, a significant detail for payers of federal income tax is how state and local taxes cannot be entirely deducted, as used to be the case, with a cap on deductions imposed. This is seen as hurting HNW individuals in higher-tax states such as New York and California. 

“Under the new legislation, planning to reduce state income taxes will become key,” Forster said. “Depending on the case, there may be possibilities for shifting the residency of a trust to a state that does not impose a state income tax (e.g., Alaska, South Dakota, Delaware, etc.) to reduce the overall effective tax rates. These jurisdictions will see an uptick in trust business.”

“Mobile individuals may migrate to no-tax states like Florida, Texas and Washington State. We are likely to see increased use of trusts and entities to own real property and shift income to other jurisdictions; correspondingly, there will likely be more challenges and litigation over state tax domiciles and the connections required for a state to impose taxation,” he added. 

The bill, in the end, fell short of scrapping estate tax entirely, as noted by Tim Steffen, director of advanced planning at Baird Wealth Solutions Group (source: Advisor Perspectives). Most of the changes, apart from those for corporates, expire after 2025, so they will return to become political hot issues again, Steffen continued. 

“In general, marginal tax rates would fall at all levels. The exception would be income for couples between $400,000 and $424,950 (and singles between $200,000 and $424,950), where the marginal rate would increase from 33 per cent to 35 per cent in 2018. This proposal did not include the `bubble tax’ that was part of the House bill, which would have eliminated the benefit of the lowest brackets for those at high income levels. Also, because the brackets for married couples are almost always twice that of a single person, this marks a significant reduction of the marriage penalty,” he said.

Suzanne Shier, who is wealth planning practice executive and chief tax strategist/tax counsel at Northern Trust, said the estate tax position wasn't as clear-cut as might appear. For example, the increase in the basic exclusion is temporary, scheduled to expire after December 31, 2025. The increase applies to lifetime gifts and transfers at death, but under both the current law and the new law, the donee of lifetime gifts receives the donor’s basis in appreciated property (carry over) whereas the beneficiary of transfers of appreciated property at death receives a new fair market value basis (step-up), she said.

"This makes a difference when the new owner later sells the property -- the higher the basis, the less the gain that is taxed. For example, if a parent purchased stock for $50, gives it to child when the stock is worth $100 and the child then sells the stock for $100, the child has $50 of gain that is taxed. On the other hand, if parent purchased stock for $50, the stock is worth $100 when the parent dies, the stock passes to the child and the child then sells the stock for $100, the child has $0 gain subject to the income tax," Shier said.
 

Mixed bag
"Under the [House] Bill, there will be winners and losers on the personal income tax side. Generally, wage earners from no‐tax states could see tax savings under the Bill. For instance, a Florida taxpayer earning $1 million with moderate itemized deductions may see a tax savings of about $30,000 under the Bill. A similar taxpayer in New York State may see a savings of about $3,500 according to our preliminary analysis,” according to US Trust, Bank of America Private Wealth Management in a note this week, written just prior to the House vote approving it. 

“Conversely, very high‐wage earners from high‐tax states could see a higher tax bill. A taxpayer earning $3 million in New York City may see a significant tax increase: $44,000 under the Bill, due in part to the loss of significant deductions. A similar taxpayer in Florida would see a tax savings of about $91,000 under the Bill (primarily due to the lower top rate, elongated 35 per cent tax bracket and regaining itemized deductions that are no longer phased‐out), according to our preliminary analysis,” it continued. 

“Married couples could fare worse than two single taxpayers with a similar amount of income. The so‐called marriage penalty hits particularly hard under the new tax brackets. The penalty is also exacerbated by permitting married couples only a $10,000 state income /real estate tax deduction, but allowing single filers a deduction in the same amount ($20,000 combined). Under the changes, a single taxpayer with $500,000 of wages living in a state that imposes a state income tax (and $10,000 of charitable deductions) would pay a federal tax of about $143,690. Two single taxpayers would pay a total of $287,380.  However, if these taxpayers were married, their joint tax liability would jump to $298,280, an increase of $10,900, it added. 

Deductions, charity and DAFs
Steffen explained that itemized deduction for state and local taxes would be capped at a total of $10,000. The limit would apply to the combined amount of income and property taxes paid during the year. However, any property or sales taxes paid in connection with a business (such as a sole proprietorship, rental property or farm) would remain fully deductible against income from that business. Property taxes paid on foreign real estate would no longer be deductible. 

At one point this entire deduction was expected to be eliminated, but this $10,000 limit was a concession to taxpayers who live in high-tax states, Steffen noted.

There could be a hit to charitable gifts because of the changed deductions regime, Steffen said – a point noted by others who have spoken to FWR about the issue.

“By limiting the deduction for income and property taxes and increasing the standard deduction, many taxpayers will switch from itemizing to taking the standard deduction. This will certainly simplify record keeping for many individuals, but it also removes an incentive to make annual gifts to charity. One strategy that may become more popular: the use of Donor Advised Funds, which can be funded with large gifts up front while delaying the actual distribution to a charity. Taxpayers may even want to create and fund these accounts before the end of 2017,” he said.
US Trust, meanwhile, said the doubling of estate tax planning could bring some unintended challenges for families. 

“It is common for wills and other testamentary documents (such as revocable trusts) to contain dispositions which reference the estate (and GST) exemptions which are in effect at death. These so‐called “formula” provisions would automatically adjust for changes in the exemption amounts. While this may achieve a beneficial tax result, the temporary doubling of the exemptions may also cause unintended consequences to the dispositive plan. For example, a common plan is to leave the estate exemption to a bypass trust, and the balance for the surviving spouse, either outright or in a marital trust,” the firm said.

It explained: “For a hypothetical $10 million estate, if death occurs in 2017 that would result in roughly half to the bypass trust and half to the spouse. However, if death occurs in 2018 to 2025, that would result in the entire estate being left to the bypass trust. Complications could further arise for individuals living in certain states which impose their own estate tax,” it said. 

Pass-through
Another important feature is how “pass-through” entities, such as partnerships, LLPs and S-corporations are taxed. US Trust said the House Bill largely accepted the Senate approach, while adding a few ideas of its own. In that case, it approaches small business relief by permitting a non‐itemized deduction of 20 per cent of qualified business income; the reduced amount would then be subject to normal marginal tax rates. Therefore, the top tax rate for business income would be 29.6 per cent, the firm said.

One sector likely to see effects from the changes is private equity, said law firm Baker & McKenzie. "Portfolio companies may have lower US federal income tax liability, which in turn could decrease the value of their tax attributes and impact their cash flow projections. Such considerations should be factored into any acquisition planning at a portfolio company level. The use of “blocker corporations” in private equity structures may have less tax leakage as a result of the lower corporate income tax rate, which may in turn impact the assessment of the use of such blocker corporations," it said in a note.

Commenting on the new three-year holding period rule as regards treatment of carried interest, the law firm firm concluded: "Private equity funds typically hold their investments for more than three years, and therefore the impact of this provision on private equity funds may not be significant. However, to the extent that a private equity fund holds any investments for fewer than three years, it will likely need to separately track the income from such investments as a result of, and in order to implement, this provision, and thus it will have an additional administrative obligation that is not currently required."